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John Mauldin

John Mauldin

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John's company, Mauldin Economics, publishes a growing number of investing resources, including both free and paid publications aimed at helping investors do better in today's challenging economy. You can find complete information about all Mauldin Economics publications here. In addition to publishing, John is cosponsor and host of the Strategic Investment Conference—an annual event for accredited investors that draws a faculty of some of the most respected investment and economic luminaries in the world. He is also a sought-after contributor to financial publications including The Financial Times and The Daily Reckoning, as well as a regular guest on CNBC, Yahoo Tech Ticker, and Bloomberg TV. John is the president of Millennium Wave Advisors, an investment advisory firm registered with multiple states. He is also a registered representative of Millennium Wave Securities, a FINRA-registered broker-dealer. Previously, he was chief executive officer of the American Bureau of Economic Research. Mauldin is one of the founders of Adopting Children Together, the largest adoption support group in Texas. He is currently on the board of directors of the International Reconciliation Coalition and has served on the executive committee of the Republican Party of Texas. John currently lives in Dallas and is the proud father of seven children, five of whom are adopted.

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Robots May Perform Half The Jobs In The US Within 20 Years: Here’s What That Could Mean

Perhaps you don’t think the change that is upon us is a profound one. But consider this: Within two decades, half the jobs in this country may be performed by robots. What then of our unemployment rate? And what of our social safety net?

Opinion is divided. Will the next technological wave further skew the wealth distribution toward the uber-rich? Or will it ultimately create more entrepreneurial and job opportunities than it destroys?

There is an interesting historical precedent for our situation. It was an era during which the technological firmament shifted just as abruptly as it is here and now.

The Industrial Revolution Makes Waves

In the UK in the year 1800, the textile industry dominated economic life. Particularly in Northern England and Scotland. Cotton-spinners, weavers (mostly of stockings), and croppers (who trimmed large sheets of woven wool) worked from home. They were well compensated and enjoyed ample leisure time.

Ten years later, that had all changed. Clive Thompson tells us what happened:

(I)n the first decade of the 1800s, the textile economy went into a tailspin.… The merchant class—the overlords who paid hosiers and croppers and weavers for the work—began looking for ways to shrink their costs.

That meant reducing wages—and bringing in more technology to improve efficiency… They also began to build huge factories where coal-burning engines would propel dozens of automated cotton-weaving machines….

The workers were livid. Factory work was miserable, with brutal 14-hour days that left workers—as one doctor noted—‘stunted, enfeebled, and depraved.’… Poverty rose as wages plummeted.

Workers Fight Back

Enter the notorious Luddites. Angry workers began to fight back. They destroyed the hated wide stocking frames and cotton-spinning machinery. They even killed factory owners.

Soon, they were breaking at least 175 machines per month. And within months, they had destroyed some 800, worth £25,000—the equivalent of nearly $2 million today.

Source: Wikimedia

As we know, the owners retaliated. The English government intervened decisively. The Luddite rebellion was crushed. However, says Thompson,

At heart, the fight was not really about technology. The Luddites were happy to use machinery—indeed, weavers had used smaller frames for decades. What galled them was the new logic of industrial capitalism, where the productivity gains from new technology enriched only the machines’ owners and weren’t shared with the workers.

The owners had taken to heart Adam Smith’s The Wealth of Nations. The book was published a few decades earlier. In it, Smith makes the case for a laissez-faire, free-market economy.

In the ensuing centuries we have seen a seesaw battle between labor and capital. It certainly appears that capital now has the upper hand. But clearly, the Industrial Revolution did lift all boats.

Can you imagine trying to support our present global population without our machines?

What About Our Future?

The Information Revolution gave us computers, the Internet, and social media. The AI Revolution is about to give us self-driving taxis and trucks and robot baristas.

Will these continue to lift our lower and middle classes? Or will they further disempower and impoverish them? Here’s what Clive Thompson thinks.

When Robots Take All Of Our Jobs, Remember The Luddites

By Clive Thompson

What a 19th-century rebellion against automation can teach us about the coming war in the job market

Is a robot coming for your job?

The odds are high, according to recent economic analyses. Indeed, fully 47 percent of all US jobs will be automated “in a decade or two,” as the tech-employment scholars Carl Frey and Michael Osborne have predicted. That’s because artificial intelligence and robotics are becoming so good that nearly any routine task could soon be automated. Robots and AI are already whisking products around Amazon’s huge shipping centers, diagnosing lung cancer more accurately than humans, and writing sports stories for newspapers.

They’re even replacing cabdrivers. Last year in Pittsburgh, Uber put its first-ever self-driving cars into its fleet: Order an Uber and the one that rolls up might have no human hands on the wheel at all. Meanwhile, Uber’s “Otto” program is installing AI in 16-wheeler trucks—a trend that could eventually replace most or all 1.7 million drivers, an enormous employment category. Those jobless truckers will be joined by millions more telemarketers, insurance underwriters, tax preparers, and library technicians—all jobs that Frey and Osborne predicted have a 99 percent chance of vanishing in a decade or two.

What happens then? If this vision is even halfway correct, it’ll be a vertiginous pace of change, upending work as we know it. As the last election amply illustrated, a big chunk of Americans already hotly blame foreigners and immigrants for taking their jobs. How will Americans react to robots and computers taking even more?

One clue might lie in the early 19th century. That’s when the first generation of workers had the experience of being suddenly thrown out of their jobs by automation. But rather than accept it, they fought back—calling themselves the “Luddites,” and staging an audacious attack against the machines.

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At the turn of 1800, the textile industry in the United Kingdom was an economic juggernaut that employed the vast majority of workers in the North. Working from home, weavers produced stockings using frames, while cotton-spinners created yarn. “Croppers” would take large sheets of woven wool fabric and trim the rough surface off, making it smooth to the touch.

These workers had great control over when and how they worked—and plenty of leisure. “The year was checkered with holidays, wakes, and fairs; it was not one dull round of labor,” as the stocking-maker William Gardiner noted gaily at the time. Indeed, some “seldom worked more than three days a week.” Not only was the weekend a holiday, but they took Monday off too, celebrating it as a drunken “St. Monday.”

Croppers in particular were a force to be reckoned with. They were well-off—their pay was three times that of stocking-makers—and their work required them to pass heavy cropping tools across the wool, making them muscular, brawny men who were fiercely independent. In the textile world, the croppers were, as one observer noted at the time, “notoriously the least manageable of any persons employed.”

But in the first decade of the 1800s, the textile economy went into a tailspin. A decade of war with Napoleon had halted trade and driven up the cost of food and everyday goods. Fashions changed, too: Men began wearing “trousers,” so the demand for stockings plummeted. The merchant class—the overlords who paid hosiers and croppers and weavers for the work—began looking for ways to shrink their costs.

That meant reducing wages—and bringing in more technology to improve efficiency. A new form of shearer and “gig mill” let one person crop wool much more quickly. An innovative, “wide” stocking frame allowed weavers to produce stockings six times faster than before: Instead of weaving the entire stocking around, they’d produce a big sheet of hosiery and cut it up into several stockings. “Cut-ups” were shoddy and fell apart quickly, and could be made by untrained workers who hadn’t done apprenticeships, but the merchants didn’t care. They also began to build huge factories where coal-burning engines would propel dozens of automated cotton-weaving machines.

“They were obsessed with keeping their factories going, so they were introducing machines wherever they might help,” says Jenny Uglow, a historian and author of In These Times: Living in Britain Through Napoleon’s Wars, 1793-1815.

The workers were livid. Factory work was miserable, with brutal 14-hour days that left workers—as one doctor noted—“stunted, enfeebled, and depraved.” Stocking-weavers were particularly incensed at the move toward cut-ups. It produced stockings of such low quality that they were “pregnant with the seeds of its own destruction,” as one hosier put it. Pretty soon people wouldn’t buy any stockings if they were this shoddy. Poverty rose as wages plummeted.

The workers tried bargaining. They weren’t opposed to machinery, they said, if the profits from increased productivity were shared. The croppers suggested taxing cloth to make a fund for those unemployed by machines. Others argued that industrialists should introduce machinery more gradually, to allow workers more time to adapt to new trades.

The plight of the unemployed workers even attracted the attention of Charlotte Brontë, who wrote them into her novel Shirley. “The throes of a sort of moral earthquake,” she noted, “were felt heaving under the hills of the northern counties.”

**********

In mid-November 1811, that earthquake began to rumble. That evening, according to a report at the time, half a dozen men—with faces blackened to obscure their identities, and carrying “swords, firelocks, and other offensive weapons”—marched into the house of master-weaver Edward Hollingsworth in the village of Bulwell. They destroyed six of his frames for making cut-ups. A week later, more men came back and this time they burned Hollingsworth’s house to the ground. Within weeks, attacks spread to other towns. When panicked industrialists tried moving their frames to a new location to hide them, the attackers would find the carts and destroy them en route.

A modus operandi emerged: The machine-breakers would usually disguise their identities and attack the machines with massive metal sledgehammers. The hammers were made by Enoch Taylor, a local blacksmith; since Taylor himself was also famous for making the cropping and weaving machines, the breakers noted the poetic irony with a chant: “Enoch made them, Enoch shall break them!”

Most notably, the attackers gave themselves a name: the Luddites.

Before an attack, they’d send a letter to manufacturers, warning them to stop using their “obnoxious frames” or face destruction. The letters were signed by “General Ludd,” “King Ludd” or perhaps by someone writing “from Ludd Hall”—an acerbic joke, pretending the Luddites had an actual organization.

Despite their violence, “they had a sense of humor” about their own image, notes Steven Jones, author of Against Technology and a professor of English and digital humanities at the University of South Florida. An actual person Ludd did not exist; probably the name was inspired by the mythic tale of “Ned Ludd,” an apprentice who was beaten by his master and retaliated by destroying his frame.

Ludd was, in essence, a useful meme—one the Luddites carefully cultivated, like modern activists posting images to Twitter and Tumblr. They wrote songs about Ludd, styling him as a Robin Hood-like figure: “No General But Ludd / Means the Poor Any Good,” as one rhyme went. In one attack, two men dressed as women, calling themselves “General Ludd’s wives.” “They were engaged in a kind of semiotics,” Jones notes. “They took a lot of time with the costumes, with the songs.”

And “Ludd” itself! “It’s a catchy name,” says Kevin Binfield, author of Writings of the Luddites. “The phonic register, the phonic impact.”

As a form of economic protest, machine-breaking wasn’t new. There were probably 35 examples of it in the previous 100 years, as the author Kirkpatrick Sale found in his seminal history Rebels Against the Future. But the Luddites, well organized and tactical, brought a ruthless efficiency to the technique: Barely a few days went by without another attack, and they were soon breaking at least 175 machines per month. Within months they had destroyed probably 800, worth £25,000—the equivalent of $1.97 million, today.

“It seemed too many people in the South like the whole of the North was sort of going up in flames,” Uglow notes. “In terms of industrial history, it was a small industrial civil war.”

Factory owners began to fight back. In April 1812, 120 Luddites descended upon Rawfolds Mill just after midnight, smashing down the doors “with a fearful crash” that was “like the felling of great trees.” But the mill owner was prepared: His men threw huge stones off the roof, and shot and killed four Luddites. The government tried to infiltrate Luddite groups to figure out the identities of these mysterious men, but to little avail. Much as in today’s fractured political climate, the poor despised the elites—and favored the Luddites. “Almost every creature of the lower order both in town & country are on their side,” as one local official noted morosely.

An 1812 handbill sought information about the armed men who destroyed five machines. (The National Archives, UK)

**********

At heart, the fight was not really about technology. The Luddites were happy to use machinery—indeed, weavers had used smaller frames for decades. What galled them was the new logic of industrial capitalism, where the productivity gains from new technology enriched only the machines’ owners and weren’t shared with the workers.

The Luddites were often careful to spare employers who they felt dealt fairly. During one attack, Luddites broke into a house and destroyed four frames—but left two intact after determining that their owner hadn’t lowered wages for his weavers. (Some masters began posting signs on their machines, hoping to avoid destruction: “This Frame Is Making Full Fashioned Work, at the Full Price.”)

For the Luddites, “there was the concept of a ‘fair profit,’” says Adrian Randall, the author of Before the Luddites. In the past, the master would take a fair profit, but now he adds, “the industrial capitalist is someone who is seeking more and more of their share of the profit that they’re making.” Workers thought wages should be protected with minimum-wage laws. Industrialists didn’t: They’d been reading up on laissez-faire economic theory in Adam Smith’s The Wealth of Nations, published a few decades earlier.

“The writings of Dr. Adam Smith have altered the opinion of the polished part of society,” as the author of a minimum wage proposal at the time noted. Now, the wealthy believed that attempting to regulate wages “would be as absurd as an attempt to regulate the winds.”

Six months after it began, though, Luddism became increasingly violent. In broad daylight, Luddites assassinated William Horsfall, a factory owner, and attempted to assassinate another. They also began to raid the houses of everyday citizens, taking every weapon they could find.

Parliament was now fully awakened, and began a ferocious crackdown. In March 1812, politicians passed a law that handed out the death penalty for anyone “destroying or injuring any Stocking or Lace Frames, or other Machines or Engines used in the Framework knitted Manufactory.” Meanwhile, London flooded the Luddite counties with 14,000 soldiers.

By winter of 1812, the government was winning. Informants and sleuthing finally tracked down the identities of a few dozen Luddites. Over a span of 15 months, 24 Luddites were hanged publicly, often after hasty trials, including a 16-year-old who cried out to his mother on the gallows, “thinking that she had the power to save him.” Another two dozen were sent to prison and 51 were sentenced to be shipped off to Australia.

“They were show trials,” says Katrina Navickas, a history professor at the University of Hertfordshire. “They were put on to show that [the government] took it seriously.” The hangings had the intended effect: Luddite activity more or less died out immediately.

It was a defeat not just of the Luddite movement, but in a grander sense, of the idea of “fair profit”—that the productivity gains from machinery should be shared widely. “By the 1830s, people had largely accepted that the free-market economy was here to stay,” Navickas notes.

A few years later, the once-mighty croppers were broken. Their trade destroyed, most eked out a living by carrying water, scavenging, or selling bits of lace or cakes on the streets.

“This was a sad end,” one observer noted, “to an honorable craft.”

**********

These days, Adrian Randall thinks technology is making cab-driving worse. Cabdrivers in London used to train for years to amass “the Knowledge,” a mental map of the city’s twisty streets. Now GPS has made it so that anyone can drive an Uber—so the job has become deskilled. Worse, he argues, the GPS doesn’t plot out the fiendishly clever routes that drivers used to. “It doesn’t know what the shortcuts are,” he complains. We are living, he says, through a shift in labor that’s precisely like that of the Luddites.

Economists are divided as to how profound the dis-employment will be. In his recent book Average Is Over, Tyler Cowen, an economist at George Mason University, argued that automation could produce profound inequality. A majority of people will find their jobs taken by robots and will be forced into low-paying service work; only a minority—those highly skilled, creative and lucky—will have lucrative jobs, which will be wildly better paid than the rest. Adaptation is possible, though, Cowen says, if society creates cheaper ways of living—“denser cities, more trailer parks.”

Erik Brynjolfsson is less pessimistic. An MIT economist who co-authored The Second Machine Age, he thinks automation won’t necessarily be so bad. The Luddites thought machines destroyed jobs, but they were only half right: They can also, eventually, create new ones. “A lot of skilled artisans did lose their jobs,” Brynjolfsson says, but several decades later demand for labor rose as new job categories emerged, like office work. “Average wages have been increasing for the past 200 years,” he notes. “The machines were creating wealth!”

The problem is that transition is rocky. In the short run, automation can destroy jobs more rapidly than it creates them—sure, things might be fine in a few decades, but that’s cold comfort to someone in, say, their 30s. Brynjolfsson thinks politicians should be adopting policies that ease the transition—much as in the past, when public education and progressive taxation and antitrust law helped prevent the 1 percent from hogging all the profits. “There’s a long list of ways we’ve tinkered with the economy to try and ensure shared prosperity,” he notes.

Will there be another Luddite uprising? Few of the historians thought that was likely. Still, they thought one could spy glimpses of Luddite-style analysis—questioning of whether the economy is fair—in the Occupy Wall Street protests, or even in the environmental movement. Others point to online activism, where hackers protest a company by hitting it with “denial of service” attacks by flooding it with so much traffic that it gets knocked off­line.

Perhaps one day, when Uber starts rolling out its robot fleet in earnest, angry out-of-work cabdrivers will go online—and try to jam up Uber’s services in the digital world.

“As work becomes more automated, I think that’s the obvious direction,” as Uglow notes. “In the West, there’s no point in trying to shut down a factory.”

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Every week, celebrated economic commentator John Mauldin highlights a well-researched, controversial essay from a fellow economic expert. Whether you find them inspiring, upsetting, or outrageous… they’ll all make you think Outside the Box. Get the newsletter free in your inbox every Wednesday.

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2 Choke Points That Threaten Oil Trade Between Persian Gulf And East Asia

 

BY GEORGE FRIEDMAN

The flow of international trade has always been subject to geopolitical risk and conflicts. At all stages of the supply chain, trade inherently faces challenges posed by the geopolitical realities along a given route.

Some routes are more perilous and harder to navigate than others. One such trade route is the maritime path for transporting oil from Persian Gulf exporters to East Asian consumers. This route faces two major choke points that are unavoidable given geographic constraints.

The Persian Gulf is a leading oil-producing region. It accounts for 30% of global supply. Meanwhile, East Asia is a major oil-consuming region. It accounts for 85% of the Persian Gulf’s exports (according to the Energy Information Administration (EIA)).

The two straits are geopolitical choke points because geographic limitations and political competition threaten access.

Choke Point #1: The Strait of Hormuz

The Strait of Hormuz is the main maritime route through which Persian Gulf exporters (Bahrain, Iran, Iraq, Kuwait, Qatar, Saudi Arabia, and the United Arab Emirates) ship their oil to external markets. Only Iran and Saudi Arabia have alternative access routes to maritime shipping lanes. 

The strait is 21 miles wide at its narrowest point, bordered by Iran and Oman. The EIA estimates that approximately 17 million barrels of oil per day—about 35% of all seaborne oil exports—pass through the strait.

This path is also the most efficient and cost-effective route through which these producers can transport their oil to East Asia. Persian Gulf countries depend heavily on revenue from these exports.

That’s why passage through the Strait of Hormuz is both an economic and a security issue. A disruption in the strait would impede the timely shipment of oil.

This would cause exporters to lose significant revenue, and importers would face supply shortages and higher costs. The longer the disruption, the greater the losses.

Disruptions could take place when Sunni and Shiite countries threaten to deny each other passage through the strait.

Shiite-majority Iran has threatened to close the strait and plant naval mines to assert its power over Saudi Arabia and other Sunni states. Saudi Arabia and its allies have conducted naval drills to show their willingness and ability to retaliate should Iran follow through.

Persian Gulf countries that depend on oil revenues have tried to mitigate this risk in two ways.

First, they’ve established alternate export routes. But the pipeline capacity is not enough to relieve dependence on the Strait of Hormuz.

Second, Persian Gulf countries have built security alliances with countries that have a vested interest in keeping the strait open. These alliances often involve the United States.

In 2016, the US received 18% of its oil imports from the Persian Gulf. As such, the US wants to maintain safe passage of exports through the strait.

Choke Point #2: The Strait of Malacca

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Reversal Rates Are the Next Big Challenge for Central Banks

 

BY SAMUEL RINES, Mauldin Economics

Negative and ultra-low interest rates have become the norm for the developed world. The phrases “lower for longer” and “new normal” are now accepted as facts rather than predictions. But, how low is too low?

For many developed world economies, rates remain low in order to combat stagnation as growth slows. Negative rates are a side effect of these deep, fundamental economic issues.

That brings up some big questions: How low? And for how long?

New research by Markus K. Brunnermeier and Yann Koby addresses this issue. They’ve tried to determine the point at which lower policy rates lose their stimulative effect.

Their research shows that lowering interest rates too far can be contractionary instead of stimulative. And the consequences are profound.

How quantitative easing really works

Before the Great Recession, the Fed Funds rate was the Fed’s main way of transmitting monetary policy. The fear then was that holding its policy rate too low for too long would cause inflation pressures to rise dramatically.

But times have changed. Now, the problem is precisely the opposite. The need to provide more stimulus has led to quantitative easing… and eventually to negative interest rates.

The process of quantitative easing is not as esoteric as it sounds. A central bank buys bonds or mortgages, typically from banks. This provides banks with reserves (cash) for assets. Banks then turn around and lend to individuals and businesses at lower interest rates than before. Economic growth ensues.

Individual banks are responsible for transmitting the policy to the economy. This means (as Brunnermeier and Koby point out) that the order of the stimulus matters.

Banks profit from loaning money out and holding bonds. So, when the Fed cuts interest rates, the value of the loans increases, which benefits the bank.

If the Fed decides it needs to conduct QE, the bank is able to sell these loans and bonds to the Fed at elevated prices. This is another benefit for the individual bank.

Eventually, this virtuous cycle ends because banks do not have endless expensive assets to sell to the Fed. This is where the “reversal rate” comes into play.

Why the reversal rate is a big problem

By lowering rates too far, a central bank removes the incentive for banks to lend. Without lending at lower rates, the bank has fewer of the assets to sell to the Fed and more volatile short-term deposits.

This breaks down the transmission of policy and creates a point at which lowering rates actually slows economic growth—the “reversal rate.”

This is why quantitative easing should always follow the lowering of interest rates. Otherwise, the higher asset prices accrue to the central bank, and the stimulus is inconsequential as quantitative easing has run its course.

This theory is not without some irony. Oddly, it negates the notion of negative and ultra-low interest rates being inherently inflationary. In fact, ultra-low rates could be disinflationary.

While the reversal rate has negative economic consequences, this does not affirm the fear expressed by the media that all negative rates are harmful. Negative rates only become harmful when they fall below the reversal rate.

A reversal rate would suggest that monetary policy has less of a margin in which to effectively operate than before. At its latest meeting, the Fed’s dot plot of projections put the “neutral” long-term rate at 2.875%, down from 4.25% at the beginning of 2012.

Assuming the US reversal rate rarely moves and is near zero, the overall monetary policy area is shrinking. In a sense, this means the Fed’s policy range shrank from 4.25% to 2.875%, which causes policy to be more difficult to execute.

In this situation, policy mistakes are more costly because there is not much in the economic toolkit to work with. It also means that quantitative easing may not be as effective as in previous cycles. In essence, if a reversal rate exists, it makes the need for infrastructure development a necessity to stimulate the economy.

The idea of a reversal rate is new. In fact, there has yet to be agreement among economists on whether it exists, and if it does, what it might be for the US. But it makes intuitive sense that there exists a level where stimulus leads to restriction.

Central banks need to rethink the process and policies by which their new unconventional tools are delivered and how long these tools should be maintained. Figuring out how monetary policy can stimulate after reaching the reversal point will prove difficult. Understanding how far is too far, and how long is too long, will be the next great central bank challenge.

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Samuel Rines is a regular contributor to Mauldin Economics. He is the Senior Economist and Portfolio Strategist at Avalon Advisors in Houston, TX.

Outside the Box: Where’s the Beef? “Lies, Damned Lies, and Statistics”

I have long been a critic of government inflation statistics. Not so much with regard to the methodology they use, but because the measure of “average” inflation across the broad economy doesn’t really describe the inflation that the majority of Americans experience. I’ve written about that at length in several letters.

Now my good friend Rob Arnott, along with his associate Lillian Wu, presents us with a research paper that lays out what inflation actually looks like for most Americans – and the picture is not pretty. The authors demonstrate that inflation in the main four categories – rent, food, energy, and medical care – has been running at roughly 3% since 1995, significantly more than the 2.2% the BLS data yields – especially when you think about the compounding effect. In the 20 years since ’95, that 0.8% differential has compounded to over 20%, which has to be deflated against incomes. When you look at the stagnant income growth of the middle class and then reduce that income by 20%, rather than by the official inflation rate, it is not hard to grasp why significant majorities in both political parties are pissed off (to employ a technical economics term). Quoting from Rob and Lillian’s paper:

Since 1995, households have expected inflation to be, on average, 3.0%, whereas realized inflation has been around 2.2%, leaving an inflation “gap” of almost 0.8%. What explains this gap? The following is our hypothesis. The four “biggies” for the average American are rent, food, energy, and medical care, in approximately that order. These “four horsemen” have been galloping along at a faster rate than headline CPI. According to the BLS definition, they compose about 60% of the aggregate population’s consumption basket, but for struggling middle-class Americans, it’s closer to 80%. For the working poor, spending on these four categories can stretch to as much as 90% of total spending. Families have definitely been feeling the inflation gap, that difference between headline CPI and inflation in the prices of goods they most frequently consume.

This paper is one of the most powerful indictments of central bank policy that I have read in a long time (even if the authors didn’t intend it to be that). It reinforces my contention that the models central banks create and the data they base those models on are inherently flawed. And those flaws are compounded because the banks’ manipulation of interest rates (the price of money) is perversely doing the opposite of what they think it should do. This is going to cause more mischief and economic pain during the next recession than any of us are prepared for or can even imagine. Seriously, we’re going to have to restructure our expectations and strategies for our portfolios to deal with what I think is developing into a policy error of biblical proportions.

And on that happy note I think I will just go ahead and let you read Rob and Lillian’s essay without further comment.

I had a long talk yesterday with my friend Murat Koprulu, emerging-market strategist type hedgie for Mariner Capital in New York. He is writing a book called The Gig Economy, based on his research into young people and their approach to working. He echoed some of the same themes that Rob’s paper does: younger and middle-class workers are getting squeezed. More and more young people are working multiple part-time gigs and are developing a very different lifestyle than their parents or grandparents were accustomed to. That dream job they hoped to get when they went to college is there; it just doesn’t pay enough to let them live in, say, New York City. And when they leave New York, the pay drops.

As I peer into our economic future, I don’t see it getting significantly better in the next 10 years. Oh, there are things a government could do to begin to turn things around, but I don’t see anybody in government willing to do those things. They keep trying to micromanage the economy and run people’s lives, and then when things don’t improve much, they think we need more of what didn’t work. The magic blue-pill “fix” for middle-class growth is not going to be manufactured by government. The world, and especially the US, doesn’t need lower rates and quantitative easing, it doesn’t need another government program. What we need is productivity and income, and those come from the marketplace. There is a role for government, but it is to be the referee that ensures a fair game, the sheriff that makes sure that everybody plays nice in the sandbox, the regulator that is there to make sure that crony capitalism and insiders don’t drive the creators out of business with unfair practices.

I will get off my soapbox and go back to my inbox. You have a great week. I get to have lunch with Peggy Noonan and listen to her speak tomorrow, which I’m greatly looking forward to. I’m sure she will help us ponder what in the wild, wild world of sports politics this coming presidential election contretemps going to look like, given the participants. Oh my, I will have a few more things to say about that in this weekend’s letter.

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Where’s the Beef? “Lies, Damned Lies, and Statistics”*

By Rob Arnott and Lillian Wu

The price of beef has been soaring over the past five years – up 80% cumulatively at the end of December 2015 – but you’d never know it by looking at the official U.S. Consumer Price Index (CPI), which is up 7%, or 1.4% a year, over the same five-year span, and therein lies our beef. The developed nations of the world, are supposedly living in a low-inflation environment, at risk of tipping over into the abyss of deflation. That’s what the folks at the U.S. Bureau of Labor Statistics (BLS) tell us. And they should know, right?  

Well, maybe not. Surveys suggest that the average American’s daily experience may be quite different. One-year consumer inflation expectations have been consistently higher than trailing and realized inflation over the last 20 years, and higher than more recent market-based inflation expectations, measured by one-year swap rates. Figure 1 shows how this divergence has grown larger since the financial crisis, suggesting the average household might have been feeling even greater pain during the recovery process than has been believed.

Since 1995, households have expected inflation to be, on average, 3.0%, whereas realized inflation has been around 2.2%, leaving an inflation “gap” of almost 0.8%. What explains this gap? The following is our hypothesis. The four “biggies” for the average American are rent, food, energy, and medical care, in approximately that order. These “four horsemen” have been galloping along at a faster rate than headline CPI. According to the BLS definition, they compose about 60% of the aggregate population’s consumption basket, but for struggling middle-class Americans, it’s closer to 80%. For the working poor, spending on these four categories can stretch to as much as 90% of total spending. Families have definitely been feeling the inflation gap, that difference between headline CPI and inflation in the prices of goods they most frequently consume.

Since 1995, the average year-over-year inflation rate for energy has been 3.9%, for food, 2.6%; for shelter, 2.7%; and for medical care, 3.6%. If we strip out all other items and recalculate the index based exclusively on these four components, we find the average rate has been about 2.9%, right in line with households’ expectations. Let us be provocative. If inflation – as experienced by the average American – is higher than official BLS “inflation,” then what exactly is the BLS statistic measuring?  

It looks like the BLS thermometer is broken! Whatever temperature they show us, the actual temperature is higher, as experienced by the average American family. For instance, the reported CPI inflation over the past 10 years ending December 2015 was about 1.9% a year. If we focus on the “big four” over the last decade, the inflation that Americans experienced was about 0.5% more. Let’s call this 0.5% difference a “measurement bias.” Paradoxically, the inflation measures for these four categories are produced by the same people who assemble the CPI. Other sources peg the gap as being considerably larger.  

These considerations have a direct bearing on our prosperity. How much real growth, for example, has occurred in the past decade? Officially, GDP has grown 1.4% a year, over and above inflation. Over the same period, the U.S. population has grown by 0.9% a year. Thus, real per capita GDP has risen by a scant 0.5% a year. Subtract the 0.5% measurement bias – probably a conservative estimate – and the average American has experienced zero growth in personal spending power over the past decade. With wealth and income concentration, if the average is flat, then median per capita spending power must be lower. Comparing 2015 with 2005, this feels about right. The official statistics do not.

The Great Recession begot a 5% reduction in U.S. real per capita GDP from the peak of 2007 to the trough of 2009. In the wake of the market collapse, major central banks around the world eased monetary conditions in lockstep with the Fed. It took nearly six years for U.S. real per capita GDP to regain its prerecession peak. This herculean task was achieved through massive spending and relentless borrowing from the nation’s current and future income. Has it worked? As always, it depends on whom you ask. We are deeply skeptical of claims that these massive interventions have helped. Real median household income has fallen by 4% since 2007, despite the “recovery” following the Great Recession! Comparing today to 1970, Figure 2 shows that real per capita GDP is up by 110% – more than doubling over the last 45 years! Yet, the median American has experienced less than one-fifth of this growth.

Middle-class Americans are struggling, as are middle-class Japanese and Europeans. Easy money, asset purchases, and negative interest rate policies of central banks across the developed world are intended to ignite the “animal spirits” of the private sector. Are they instead stifling economic and wage growth? Are they stimulating asset hoarding and bubbles, which fuel widening gaps between the haves and the have-nots, and feed class resentment? Are they leaving inflationary pressures unchecked and hollowing out opportunities for the middle class? These are provocative suggestions, which go against neo-Keynesian theoretical dogma, but they fit the objective evidence we see all around us. Sometimes common sense trumps theory.

Former Fed Chairman Ben Bernanke was quite candid in saying that zero interest rates and quantitative easing were intended to create a “wealth effect.”  He wanted asset values to rise so the affluent would spend more, so the economy could boom. He achieved the first of these: asset values rose. But who owns assets? The wealthy. What this “stimulated” is a growing gap between the haves and the have-nots: the wealthy got wealthier. That’s redistribution, backwards. Then, in a towering act of hubris and hypocrisy, the central bankers collectively deny they played any role in widening the income and wealth disparity, or in hollowing out the middle class. Ouch. But although the rich began to spend more, the impact on the economy was limited. If the rich mostly buy more assets (i.e., stocks, bonds, real estate, art, collectible cars, rather than “new stuff” that needs to be manufactured), doesn’t that just fuel more bubbles?

And let’s not forget the downside of bull markets. The benefits to the rich of accommodative monetary policy are short lived. The values of the assets they own soar, but the forward-looking returns on those assets crater. (Notice how hard it is to find a liquid mainstream market that offers real after-tax returns much above zero these days.) Then, net of spending and charitable giving, their wealth dissipates assuredly and rapidly, recycled into the economy with no assistance needed from the Pikettys of the world. The wealth of the richest is fleeting, typically dissipated by the third generation (Arnott, Bernstein, and Wu, 2015).

Worse, lousy forward-looking returns also afflict the young and the shrinking middle class. The future returns on their pension assets are horribly low, but the average American must prepare for retirement now, not later when the artificial policy-induced bull market ends and prices settle to more sensible levels. As a result, they invest their hard-earned money in the S&P 500 and hope for the best. Unfortunately, hope is not a strategy. To add insult to injury, their kids have essentially zero incentive to invest for the future or to buy (not at today’s prices!) those self-same assets from their parents to help transform them into goods and services their parents can consume in retirement. Zero-interest rate policies have crushed the opportunities and incentives for the middle class – and their kids – to save and invest. 

The middle class is getting squeezed from every direction and is sadly disappearing. In 2008, according to Pew Research Center, 53% of adults considered themselves middle class. A scant 6 years later in 2014, as Figure 3 illustrates, that number had dropped precipitously to 44%. At this rate of decline, in 30 years there’ll be no middle class left! For the class warriors, don’t worry, be happy – the self-identified upper class has shrunk from 21% to 15% in that same 6-year span, so they’ll be gone in just 15 years!

We’re being deliberately provocative; we do not expect this to happen because pendulums swing both ways. But this particular swing of the pendulum is profoundly disturbing and is doing a lot of damage to what was once called “American exceptionalism.”

New business start-ups suffer too. Individual investors hesitate to fulfill their dreams of beginning their own businesses – home to the majority of our economy’s jobs – because they don’t know the cost of capital. Near-zero interest rates aren’t available to them, and the future cost of capital is unknown but presumed to be higher. The prospective regulatory regime three to five years hence is shrouded in mystery too. Corporations, like investors, are deeply wary about long-horizon investments with uncertain prospects. Why plow funds into long-term risky business ventures when low-risk (but, of course, high-priced) stock is available for buybacks and can be funded with near-zero-rate financing? The endgame is that the economy stagnates and the middle class slowly slips underwater. Is this speculation or fact? January 2016 was one of only a few months since the Great Depression with no IPOs.

The fears surrounding the global economy and the calls for negative interest rates highlight the uncertainty surrounding the near future. When central banks finally step away from overt market interventions, however, capital market valuations will presumably revert to the levels that would prevail in the absence of intervention. Does anyone think that will mean higher price levels?  Didn’t think so. Accommodative monetary conditions inflate asset prices into asset bubbles that sooner or later will seek their fair value. If the interventions are artificially propping up asset prices, the average investor is justifiably wary. If fair values are lower, the good news is that, after the one-off adjustment, forward-looking returns will once again be sensible. 

Big Brother cannot take care of us. Only we can do that. Big Brother is us; the government is us. If we think a bureaucrat can take care of us better than we can take care of ourselves, or cares more about us than we care about ourselves, we’re deluded. The more we think we can offload our own responsibility for self-reliance – the longer we take to look under the bun and ask, “Where’s the beef?” – the more we invite our elite leaders to continue with the interventionist policies that have inflicted so much damage already.

* Benjamin Disraeli (1804-1881) served twice as Britain’s prime minister and famously described the three kinds of deception, hierarchically from least to worst, as “lies, damned lies, and statistics.”

Reference 

Robert D. Arnott, William Bernstein, and Lillian Wu. 2015. “The Myth of Dynastic Wealth: The Rich Get Poorer.” Cato Journal, vol. 35, no. 3 (Fall):447–485.

3 Reasons Saudi Arabia Is So Desperate for Cash

Early this year, the Crown Prince of Saudi Arabia revealed that Saudi Arabia is considering an initial public offering for state-owned oil company Aramco. Chairman of Aramco Khalid al-Falih later clarified that the IPO would not include Saudi Arabia’s oil reserves, estimated at 268 billion barrels.

“The reserves will remain sovereign,” al-Falih said in an interview with Al-Arabiya. He added that the kingdom is mulling options for an IPO of the firm’s “ability to convert these reserves into a financial gain.”

The statements were vague and the Saudis’ actual plan for the IPO remains unclear. However, whether or not the IPO happens is not important. What is vitally important is that it was publicly discussed by the Crown Prince of Saudi Arabia.

Aramco is the world’s most valuable company. It’s also one of the most important sources of geopolitical power for Saudi Arabia. And the Crown Prince was fully aware of the consequences the statement would cause.

All of this reveals what a desperate situation record-low oil prices have pushed the Saudi’s regime into.

The Kingdom Has Only 3–5 Years of Cash Reserves Left

There is one key principle driving Saudi Arabia to sell shares in Aramco: the kingdom needs money to buy time.

The Saudi Arabia Monetary Authority (SAMA) acknowledges that the country ran a deficit of 21.6% of GDP in 2015—a quantum leap from 3% the prior year. They hope to cut that to 13% in 2016. However, the IMF expects a deficit of 20% in 2016.

They have burned through almost $100 billion in reserves the last few years. A second, similarly sized deficit would consume another $100 billion. Reserves now stand at roughly $650 billion.

The problem with those estimates is that they assume an average price for Saudi light crude of $50 in 2016. As we write this article, West Texas Intermediate (WTI) is priced around $30. And that is the delivered price of oil. The actual price a producer gets is even less.

So, what happens to Saudi Arabia’s budget deficit if oil stays in the $30 rather than $50 range?

Bank of America Merrill Lynch gives us the following estimates:

3_Reasons_Saudi_Arabia_Is_So_Desperate_for_Cash

Even with a 25% budget cut, Saudi Arabia would have just three to five years of reserves and borrowing available at $30 oil. We note that several respected investment banks are projecting that oil will fall to $20 this year.

If a crisis in Europe or China were to even slightly reduce global demand, $20 oil seems a very real possibility.

The Saudis Need Money to Hold the Arab World Together

Saudi Arabia has been spending lots of money to keep the Arab world—itself in a state of crisis— intact. Many Arab states have either collapsed or been severely weakened.

Saudi Arabia now confronts at least two key external challenges: Iran and the Islamic State.

Saudi Arabia sees itself as an enemy of Iran. As neither side is powerful enough to wage war on the other, they instead wage various (and very expensive) proxy conflicts throughout the region.

Beyond fighting proxy wars, Saudi Arabia also supports Arab states in economic turmoil, including Bahrain, Jordan, Morocco, and Egypt. They are attempting to lead a Sunni Arab coalition against Iran—and using their wealth to cement those relationships.

Saudi Arabia’s other external challenge is the rise of jihadist groups. The most significant of these groups is the Islamic State (IS). At this point, IS is behaving much like a state and has declared a caliphate in large parts of Syria and Iraq.

Saudi Arabia, therefore, is committing large amounts of monetary support to rebels in Syria fighting IS because it fears they could attack the kingdom. IS has been already staging attacks on Shiite mosques in Saudi Arabia and leveraging the region’s polarized sectarian climate to undermine the kingdom’s security.

Saudi Arabia Faces Serious Internal Challenges

The foundation of the country’s social system is the state’s ability to maintain a safety net for various segments of Saudi society. 70% of Saudi Arabia’s population is under the age of 30.

The government provides large subsidies for commodities like food and oil and offers social services and education for its majority Sunni Arab population.

The Saudi government currently provides free healthcare, free education, subsidized water and electricity, no income tax, and paid-for public pensions. Nearly 90% of Saudis are employed by the government, often at higher wages than the private sector offers.

Saudi Arabia also has a significant Shiite minority—possibly 20% of the total population. Riyadh has to somehow manage this group so that Tehran cannot overly influence it.

The Kingdom’s current financial straits render it unable to dramatically increase the money it throws at problematic groups in the country like dissident, reformist Shiites and jihadists. State-sponsored domestic spending that keeps the kingdom cohesive has also been cut, which poses serious risks to the social and economic stability of Saudi Arabia.

Desperate Times Call for Desperate Measures

The kingdom is built on oil money, and that money was used to create a technologically advanced and powerful country.

But the plummet in oil prices with no sign of a quick recovery, a brewing crisis of succession, the potential for domestic unrest due to budget cutbacks, and unprecedented external challenges have pushed Saudi Arabia in a hazardous direction: the consideration of an IPO for their most valuable asset, Aramco.

How the Fall of Saudi Arabia Could Lead the World to the Edge of Disaster

Grab the free report Saudi Arabia—a Failing Kingdom from John Mauldin and George Friedman, which is a must read for every investor who wants to protect their assets… and profit from what happens next.

Even if you have no oil stocks in your portfolio, this report could be vitally important to prepare you for coming events. Because whenever oil and the Middle East are in play, ultimately the whole world will be affected. Claim your free copy right now!

The article was excerpted from the report Saudi Arabia—a Failing Kingdom.

Here’s Why Nobody Understands the Markets

BY JARED DILLIAN

I used to be a big astronomy nerd when I was a kid, locked up in my room, reading space books. I actually was once interested in planetary science. Now I study finance. How depraved.

Nassim Taleb is right—finance actually is depraved. If you study finance, you study money, of course. But why is money interesting?  Because it doesn’t sit around in static piles that you shuffle and count. It can grow asymptotically, or else simply disappear.

This is true not just of stocks and bonds, but also of currencies, which are supposed to be worth something, and even commodities, which are really supposed to be worth something.

Then you have gold, which is totally useless from a practical standpoint and whose value fluctuates dramatically.

Funny thing about money exploding or disappearing is that it’s so hard to understand that we hire physicists to figure it out. 

And then they come up with these really mundane solutions, like an options pricing model that doesn’t work, or a way to forecast future volatility (that also doesn’t work). 

None of this ever comes close to figuring out why money explodes or disappears.

Human Behavior is Unquantifiable

The reason we aren’t any closer to the answer is because we keep using the wrong methods. 

You can get the math geeks to come up with equations to describe human behavior, but then human behavior changes or does something new, and you are back to square one.

The study of money is the study of people, and people behave in sometimes predictable, but often unpredictable ways. Just when you think you have a rubric (like Nate Silver with elections, a related field), along comes a Trump who blows apart the whole model.

I’ve always felt that finance is a very qualitative discipline. You are no worse off hiring English or history majors. It’s no accident that all the heavy hitters in this business are also really great writers.

The quants are starting to catch on, and a lot of the algorithmic traders are writing programs to mimic and predict human behavior… though it’s really just technical analysis and trend following in a computer program. Technical analysis has an uneven reputation, but when you can quantify and backtest it and it works, the reputation gets markedly better.

Hard to argue nowadays that even weak-form EMH holds when you have a cottage industry of very profitable systematic strategies.

Of course, there is a lot of math behind the quant stuff, and the guys doing it are mathematical geniuses, but the best of them are also very sharp market folks with a nose for when trades start to get crowded. 

The quant blowup of 2007 happened because all the smart quants were in all the same ideas. So even in the world of high-level mathematics, you still have to deal with unquantifiable stuff: human behavior.

When someone like hedge fund manager Bill Ackman sees his portfolio get slaughtered by about 20% in 2015 and then double digits in the first month of 2016, that’s not just bad stock-picking. This is what happens when crowded trades become un-crowded.

Computers may be computers, but the people who program the computers are just human and utterly fallible.

Why I Believe in Behavioral Finance 

When I taught my college finance class last semester, I’d say the most consensus long among the students was Disney (DIS) because of Star Wars.
 

Here’s Why Nobody Understands the Markets

Of course, I had been doing a bunch of work on the short side for months.
Disney has some serious problems like declines in sports viewing and superhero movies and cable industry trends—secular stuff that’s completely out of their control. 

Suffice it to say that by the time the MBA students in South Carolina get bulled up on a stock, it is probably pretty close to the end.
That’s behavioral finance in a nutshell.

This is what I do for a living. I watch the market, not the stocks, if that makes any sense. I am always collecting data. Every person I talk to on the phone, every chart I look at, every tweet or article I read, it all goes into the soup, and from that soup, I am trying to gauge sentiment.

Sentiment tells you everything. Cheap things get cheap, and expensive things get more expensive. Markets are alternately rational and irrational because people are alternately rational and irrational. Seems like a crazy way to allocate resources, but it works better than all the alternatives.

If you want to read more about my investment process, you can choose between the monthly version or the daily.

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A master in behavioral economics, Jared probes the mind of today’s market to gauge the trends of tomorrow. Following his intellectual adventures is a true thrill ride for every investor. Sign up for his weekly missive, and don’t miss another one of his captivating conclusions.

The article Here’s Why Nobody Understands the Markets was originally published at mauldineconomics.com.

Thoughts From the Frontline: The Fed Prepares to Dive

 

“No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.”

– Ben Bernanke, 2009

“I think negative rates are something the Fed will and probably should consider if the situation arises.”

– Ben Bernanke, December 2015

“In theory there is no difference between theory and practice. In practice there is.”

– Yogi Berra

Economists used to think below-zero interest rates were impossible. Necessity (as central banks see it) is the mother of invention, though; and multiple central banks now think negative rates are a necessary step to restore growth.

Are they right? Will negative rates pull the global economy out of its funk? Probably not; but for better or worse, several central banks are already below zero. The Federal Reserve just sent its clearest signal yet that it is headed that way, too. The Fed has warned banks to get ready. We had all better do the same.

This week’s letter has two parts. The first deals with some of the practical aspects of negative rates and what the Fed is really signaling. The second part, which is somewhat philosophical, deals with why the Fed will institute negative rates during the next recession. This letter is longer than usual, but I think it’s important to understand why we will see negative rates in the world’s reserve currency (and the currency in which most global trade is conducted). This policy trend is truly a foray into unexplored territory.

Be Careful What You Wish For

The idea of negative rates isn’t new; what’s new is the willingness to try them out. The Ben Bernanke quote above comes from a November 2, 2009, Foreign Policy article in which the Fed chairman wrestled with how to keep inflation at the “right” level in a weak economy.

Set aside the question of whether there is any “right” level of inflation. As of six years ago, the head of the world’s most important central bank thought no one would ever lend at a negative interest rate. We now know he was wrong, at least with regard to Japan and most of Europe. Central banks there have instituted negative rate policies, and people are still borrowing and lending.

The Fed staff has also speculated on the possibility. Earlier this month my good friend David Kotok sent around links to several academic and central bank negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time: “If Interest Rates Go Negative… Or, Be Careful What You Wish For.”

Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. All kinds of incentives would reverse, for starters.

Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible. Think about your credit card bill. If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice. Could they? We don’t know.

Garbade and McAndrews throw out another interesting idea: special-purpose banks:

If rates go negative, we should expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower than that.

Ludwig von Mises fans will recognize that this approach is not far from the Austrian economics goal of 100% reserve banking. It isn’t quite there because the vault contains fiat currency instead of gold, but I think Mises would recognize it as a step in the right direction. (The fact that Fed economists see it only as an exotic theoretical possibility wouldn’t surprise him, either.)

The consequences of such banking would be more than theoretical. If enough people wanted to use these special-purpose banks, demand for physical cash would go through the roof. There simply wouldn’t be enough to go around if it just sat in vaults instead of circulating. Furthermore, if the vaulted cash in these banks reduced deposits in normal loan-making banks, the whole banking system might grind to a halt.

That being the case, I suspect the Fed would prohibit banks from operating this way – but they can’t stop people from hoarding cash under their mattresses. The one thing they could do is eliminate physical cash. Denmark, Sweden, and Norway are already considering ways to do so.

Even more ominously, Bloomberg reported on. Feb. 9 that a move is afoot for the European Central Bank to get rid of 500-euro notes, the Eurozone’s largest-denomination bills. They portray this move mainly as a crime-fighting measure, but it would clearly make cash hoarding much more difficult.

And if Larry Summers and a few other well-known economists like Ken Rogoff have their way, we will see the demise of the $100 bill in the US. You thought you were just carrying those Ben Franklins around for convenience, not realizing that they make you a potential drug dealer in some people’s eyes.

And of course, hoarding cash would undermine the Fed’s goal of fighting deflation. Holding cash is by definition deflationary.

If Crazy Doesn’t Work, Try Crazier

All of the above is just speculation at the moment. We don’t know how deeply negative rates would have to go before people change their behavior. So far the negative rates in Europe and Japan apply mainly to interbank transactions, not to individual depositors or borrowers. Unless of course you are buying government bonds.

That said, we’ve seen a clear tendency on the part of central banks since 2008: if a crazy policy doesn’t produce the desired results, make it even crazier. I believe Yellen, Draghi, Kuroda, and all the others will push rates deep below zero if they see no better alternatives. And my best guess is they won’t.

 Turns out negative rates aren’t exactly new. My good friend David Zervos, chief market strategist for Jefferies & Co., sent out a note this week pointing out that many “real,” inflation-adjusted rates have actually been negative for years. Such rates have thus far not produced the kind of reflation that central banks want to see. David thinks the ECB and BOJ should push nominal rates down to -1%, launch new quantitative easing bond purchases of at least $200 billion per month, and commit to do even more if their economies don’t respond.

Is Zervos losing his mind? No, he actually makes a pretty good case for such a policy – if you buy into his economic theories, which I discuss in the second part of this letter. (Over My Shoulder subscribers can read Zervos’s note here.) It is painfully clear to most of us that what the central banks have done thus far has not worked. I have a hard time imagining that a major NIRP campaign will help, but I’ve been wrong before.

Former Minneapolis Fed President Narayana Kocherlakota, who was for years the FOMC uber-dove, says going negative would be “daring but appropriate.” He has a number of reasons for this stance. In a note last week, he said the federal government is missing a chance to borrow gobs of money at super-attractive interest rates.

Kocherlakota would like to see the Treasury issue as much paper as it takes to drive real rates back above zero. He would use the borrowed money to repair our rickety infrastructure and to stimulate the economy.

It is an appealing idea – in theory. In reality, I have no faith that our political class would spend the cash wisely. More likely, Washington politicians would collude to distribute the money to their cronies, who would build useless highways and bridges to nowhere. The taxpayers would end up stuck with more debt, and our infrastructure would be little better than it is now.

The fact that this is a “monumentally” bad idea doesn’t mean it will never happen. There’s an excellent chance it will happen. Yellen and the Fed are clearly looking in that direction.

Yellen & the Spirit of Prudent Planning

Yellen might face one small problem on the road to NIRP: no one is completely sure if the Fed has legal authority to enact such a policy. An Aug. 5, 2010, staff memo says that the law authorizing the Fed to pay interest on excess reserves may not give it authority to charge interest.

This potential snag is interesting for a couple of reasons. With last month’s release of this memo, we now know the Fed was actively considering NIRP less than a year after Bernanke himself said publicly that “no one will lend at a negative interest rate.” Meanwhile, some at the Fed were clearly examining the possibility.

What else was happening at the time? The bond-buying program we now call QE1 had just wrapped up in June 2010. The Fed launched QE2 in November 2010. This memo came about because the Fed realized it needed to do more and was considering options. QE2 apparently beat out NIRP as the crazy policy du jour.

The question of the legality of negative rates came up again in congressional testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked Yellen if the Fed had authority to impose negative interest rates. According to press reports, she skirted a definitive answer:

In the spirit of prudent planning we always try to look at what options we would have available to us either if we needed to tighten policy more rapidly than we expect or the opposite. So we would take a look at [negative rates]. The legal issues I’m not prepared to tell you have been thoroughly examined at this point. I am not aware of anything that would prevent [the Fed from taking interest rates into negative territory]. But I am saying we have not fully investigated the legal issues.

We know the Fed was investigating the legal issues as long ago as 2010. I would be shocked to learn that they did not investigate those issues thoroughly in the six subsequent years. Various Fed officials – including Yellen – have openly speculated about NIRP. The Fed’s legal team should be disbarred for malpractice if it hasn’t fully investigated yet. I think Yellen’s testimony was a way to deflect the potential controversy as long as possible. I believe the Yellen Fed will telegraph the markets about negative rates prior to implementing them, but evidently Yellen feels it is too soon to send that signal now.

Of course, Yellen also says she is “not aware of anything that would prevent” a NIRP move. So she may do it and then blame her lawyers if someone cries foul. By then the policy would be in place and probably irreversible. In Washington, forgiveness comes easier than permission does.

In the same testimony, Yellen hinted that the previously forecast March rate hike is probably off the table now. We will get new “dot plot” forecasts, though. It will be interesting to see how dovish they are.

As I’ve said, I am firmly convinced that the Fed will not raise the federal funds rate even to 1% this year. December may well have been the last hike we will see for some time. I can see the Fed holding steady for several months. And they are clearly getting ready to introduce negative rates during the next recession. They are already telling banks to get ready for them, too.

Y2K All Over Again?

The Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major banks. They do this by giving the banks a set of hypothetical economic scenarios. They released this year’s scenarios on Jan. 28.

The “severely adverse” scenario instructs banks to test their systems for a deep recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%, and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.

Is this “severely adverse?” It’s far less adverse than what Japan has already experienced. BOJ purchases have driven Japanese government bond yields negative 10 years out the curve. Rates are also negative far out the yield curve all over Europe, even in countries that don’t deserve such rates, let alone midterm rates with even a one or a two handle.

The stress test scenarios aren’t a forecast, per se, but they mean the Fed at least sees those conditions as possible. The whole exercise is pointless if the scenarios could never happen. I think this stress test scenario is the clearest sign yet that the Fed views NIRP as a legitimate alternative.

It doesn’t mean NIRP is guaranteed. I believe Yellen when she says their policy is “data-dependent.” They are no more prescient about the future than the rest of us are. All they can do is look at the data and try to respond appropriately. I don’t envy them that job.

I think the Fed is right now in a position much like the one that was portrayed in that 2010 staff memo. They see their last big move as not having had the desired effect and are considering a new set of options. NIRP is on their list.

Having decided to put NIRP on the list, the Fed has to make sure the banking system can handle it. Whether it can is far from clear right now. The technology issues alone could unleash chaos if the Fed went negative without warning. I think putting negative rates in the stress test scenarios is the Fed’s not-so-subtle message to Wall Street: “Get ready; this could really happen.”

If Europe’s experience means anything, it seems likely our banks aren’t ready yet. Consider this Mar. 4, 2015, Wall Street Journal story.

Widespread negative interest rates, once only a theoretical possibility, have become a real-life problem for Europe’s financial system.

From Sweden to Spain, banks, brokers and other financial firms are grappling with technical and legal glitches thrown up by negative rates, forcing them to redesign computer systems, tear up spreadsheets and redraft legal contracts.

The issue echoes the scrambles around the Year 2000 computer bug and the launch of the euro, when some bank systems couldn’t handle the introduction of a new currency, said Kevin Burrowes, head of U.K. financial services at PricewaterhouseCoopers. A handful of malfunctioning computer programs can cause “huge problems,” while working around problems manually makes more controls necessary and increases the risk that something could go wrong, Mr. Burrowes said.

Preparing for NIRP is a far smaller challenge than preparing for Y2K, which required years of reprogramming and hundreds of billions of dollars, but it is still a huge project. Some reports say European banks are still dealing with the programming issues. And technology is only part of the problem. Think of all the contracts and other legal documents that might need rewriting and renegotiation. If nothing else, the Fed just stimulated the securities and contract law businesses.

One small example from my personal experience: I have been involved in the management of several large commodity funds over the past 25 years. Back in the day, commodity funds had a significant advantage in that they could put 90% of their money into short-term government bonds to generate the capital for their futures contracts. This interest offset a lot of their fees in the ’80s and ’90s. Not so much today. I suspect that many of the organizational documents required still state that such funds will use short-term Treasuries as their cash base.

Requiring these funds to lose ½% would mean they start in the hole. Not what a fund manager wants to do. But it has to be short-term cash, as the money has to be available on very short notice since it’s the collateral for a futures contract. I’ve sat and thought about this and still haven’t come up with a way around this. I wonder how many other funds will have the same issue. (We will discuss this subject in further depth in a few paragraphs.)

Go Thou and Do Likewise

The Fed is specifically warning banks, but NIRP will affect the whole economy. If you own any kind of business or you are an active investor, I expect that NIRP will create significant headaches for you. Are you ready?

Most of us have no idea whether we’re ready, but we might be able to find out. Here’s a simple test. Go to whatever accounting software or spreadsheet program you use, find the interest rate setting and see if it will let you enter a negative number.

If it won’t accept a negative rate at all, now might be an excellent time to update your software.

If the program does let you show a negative rate, dig a little and see how that rate affects the rest of your bookkeeping. Most of us have created numerous Excel spreadsheets. You know that if you get your programming off a little bit, you end up with  ##### signs in some of the cells. When you enter negative interest rates into your software, you may find similarly weird things happening. They could be good-weird or bad-weird, but in either case you might want to consult your brokerage firms, investment advisors, accountants, and tax advisors about possible consequences.

While you’re at it, think about how the rest of the Fed’s “severely adverse” scenario might affect you. Here is the guidance the Fed gave the banks:

(Yes, I know they spelled severely wrong. Clearly the Fed needs a new proofreader along with new policies. That said, you just can’t catch all the mistakes. There are at least three professional editors who read my letter prior to publication, and misteaks still happen.)

I didn’t even mention the Fed’s stock market scenario in the right column above. It shows the Dow dropping almost to 10,000 by the end of this year and recovering very slowly. In a world where anything is possible, I suppose it is prudent to ask what if questions. I do not see the Dow’s dropping 10,000 points this year, but in a deep recession? That plunge would not be out of the realm of historical precedent. If banks are planning for adverse scenarios, it would be a good idea for you to do so, too, even if you think there is no chance in hell those scenarios will play out. Contingency planning is simply prudent management. Don’t let a recession catch you without a plan.

The Religion of Economics

The problems posed by negative rates are mostly practical in nature, but they come with some deeply disturbing side effects. In the discussion above I didn’t venture into the theoretical problems of misallocation of capital, the negating of Schumpeter’s creative destruction cycle, the even more intense repression of savers and retirees, and the absolute devastation negative rates would wreak up on pension, endowment, and insurance company portfolios.

In a world of ultralow rates, pension funds that are targeting 7½% growth in order to meet their funding needs 20 years out will find those targets are impossible to attain (as they are today, only moreso). It is not yet obvious to the general public how deeply underfunded pensions are, because pension funds are still assuming that future returns will be in the 7½-8% range. That pension or annuity you are counting on for your retirement is most likely in serious trouble. And as people get older and have no practical way to go back to work, pension funds that are forced to reduce payments in 10 or 15 years (and some even sooner) will destroy the lifestyles of many of our elderly. You think there is a violent backlash among voters today? Just screw around with pensions…

So what would make central bankers around the world agree that negative rates are a solution to our current economic malaise? And that, with all their known negative consequences, not to mention their unknown unintended consequences, negative rates are better than the alternative?

I have been trying to devise an explanation of the negative rates proposition that most people can grasp by likening prevailing economic theories to a religion. Everyone understands that there is an element of faith in their own religious views, and I am going to suggest that a similar act of faith is required if one is believe in academic economics. Economics and religion are actually quite similar. They are belief systems that try to optimize outcomes. For the religious that outcome is getting to heaven, and for economists it is achieving robust economic growth – heaven on earth.

I fully recognize that I’m treading on delicate ground here, with the potential to offend pretty much everyone. My intention is to not to belittle either religion or economics, but to help you understand why central bankers take the actions they do.

This explanation will need a little set-up. I have noted before, in an effort to be humorous, that when you become a central banker you are taken into a back room and given gene therapy that makes you always and everywhere opposed to deflation. Actually, this visceral aversion is imparted during academic training in the generally elite schools from which central bankers are chosen.

This is our heritage; it’s learning derived not only from the Great Depression but from all of the other deflationary crashes in our history, too, not just in the US but globally. When you are sitting on the board of a central bank, your one overriding rule is never to allow deflation to occur on your watch. No one wants to be thought responsible for bringing about another Great Depression.

And let’s be clear, without the radical actions taken in 2008–09 to bail out the banks, drop rates to the zero bound, and institute quantitative easing, we would likely have been facing something similar to the Great Depression. While I don’t like the manner in which we chose to bail out the banks, some form of bailout was a necessary evil.

Think deflationary depressions can’t happen today? Clearly, they can. Greece, for all intents and purposes, has sunk into a massive deflationary depression. That reality is not necessarily reflected in the prices of their goods, which are denominated in euros. No, the deflationary depression in Greece is in their labor market.

Normally, when a sovereign country gets into financial trouble (generally because of too much debt), it will devalue its currency so that the prices of products it imports go up and labor costs and the prices of products it sells abroad go down. But since Greece could not devalue its currency (the euro), it was essentially forced to allow its labor costs to fall drastically. Since it is basically impossible to go to everyone in Greece and say, “You need to take a 25% cut in your pay, even though the prices of everything you’ll be buying will still be in euros,” the real world simply produced massive Greek unemployment – precisely what you would expect in a deflationary depression. Greece will likely continue to suffer for a very long time, whereas if the Greeks had left the euro, defaulted on their debts, and devalued their currency, they would likely be enjoying a quite robust recovery.

Greece’s present is a possible near future for other countries in Europe (Portugal is likely to be next, and Italy will surprise everyone with its severe banking problems), which is why the European Central Bank is so desperately fighting the deflationary impulse embedded in the very structure of the European Union.

Now, the United States is clearly not Greece. However, we are subject to the same laws of economics.

By definition, recessions are deflationary. Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective. If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever. Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together. It’s a Hobson’s choice; you see no other option.

Let’s do a little sidebar here. There’s lots of discussion in the media of the possible moves the Federal Reserve could make. Some people talk about the Fed’s buying the government’s infrastructure bonds, or buying equities or corporate bonds, or even doing the infamous “helicopter drop” of money into outstretched consumer hands. Those are not legal options for the Fed. The Fed is actually fairly restricted in what it can purchase. All of these outside-the-box transactions would require congressional approval and amendment of the Federal Reserve Act.

I can tell you that there is almost no stomach in the leadership of Congress or at the Fed to bring up the Federal Reserve Act for congressional action. Everyone is worried about potential mischief and political sideshows. Quite frankly, if the Federal Reserve decides that it wants to do more quantitative easing, I would much prefer that Congress authorize the Fed to purchase a few trillion dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to do an actual helicopter drop. The infrastructure bonds would create jobs and give our children something for their future, a much healthier outcome than the ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative easing. In those instances, the benefits of QE went primarily to the well-off. But I digress.

The reigning academic orthodoxy for central bank believers is Keynesianism. Saint Keynes postulated that consumption is the fundamental driver of the economy. If the country is mired in recession or depression, then government and monetary policy should be geared toward increasing consumption in order to spur a recovery. Keynes argued that the government should be the consumer of last resort, running deficits as deep as necessary during recessions. (He also advocated paying down the debt during the good times, prudent advice roundly ignored.)

The current belief in vogue is that another way to increase consumption is to get businesses and consumers to borrow money and spend it. Hopefully, businesses will invest it and create new jobs, which will in turn enable more consumption. One way to stimulate more borrowing is to lower the cost of borrowing, which the Federal Reserve does by lowering interest rates. The opposite is also true: if inflation is a problem, the Fed raises rates, taking some of the inflationary steam out of the economy.

How would negative rates work? The Federal Reserve would charge a negative interest rate on the excess reserves that banks deposit at the Fed. Note this is not a negative interest rate on all deposits, just on “excess reserves” on deposit at the Fed. An excess reserve is a regulatory and political concept that is a necessary feature of the fractional reserve banking systems of the modern world. Banks are required to maintain a reserve of their assets against possible future losses from their loan portfolios. The riskier the assets the banks hold, the less those assets count towards the required level of reserves. Reserves are required to keep a bank solvent. Banks are closed and sold off when their reserves and capital are depleted below the allowed levels.

Any reserves in excess of the regulatory requirements are counted as “excess.” The theory is that if the central bank charges banks interest on their excess reserves, the banks will be more likely to lend that money out, even if at a lower rate, in order to at least make something on those reserves. Right now, banks are paid by the central bank for their excess reserves on deposit. Given the level of excess reserves at the Fed, these interest payments amount to multiple billions of dollars that are fed into the banking system each quarter; and that is one of the reasons why US banks have been able to get healthier in the wake of the Great Recession.

Consumers and businesses would borrow this cheaper money from the banks and presumably spend it or otherwise put it to use, thereby stimulating the economy and vanquishing the evil of deflation. In theory, as the economy recovers, interest rates are allowed to rise back above the zero bound.

Of course that was the theory when we went to zero rates some six years ago. At some point the economy would recover and the Fed would normalize rates. Except the economy never got to a place where the Fed felt comfortable raising rates even minimally – until last December. And now the high priests of the FOMC are signaling that it might be longer than they originally thought before they swing their incense orbs and raise rates again.

There are some (including me) who would argue that, rather than focusing on consumption, monetary and fiscal policy should focus on increasing production and income. By lowering (repressing) the amount of income savers get on their money, you push savers into riskier assets. That is generally not what you tell people to do with their retirement portfolios, (nor can we overlook the fact that the country is getting older). Thus if interest rates are artificially low because of Fed policy, that reduces the amount of money retirees have to spend. The Federal Reserve and central banks in general seems to think it’s better to have consumers borrow than save.

It’s a Keynesian conundrum. If nobody spends and everybody saves, the economy slows down. While it may be a good thing for you individually to save and prepare for your retirement, if everybody does so at the same time the economy plunges into recession.

Now let’s get back to the intersection of economics and religion. There are multiple competing economic theories on the government’s role in monetary policy making. The operative word is theories. Each is an attempt to describe how to manage a vastly complex modern economy. Some see too much debt as the cause of our current malaise. Others think that lowering taxes would allow consumers and businesses to keep more of their income and hopefully spend it.

In the not too distant human past, shamans and soothsayers conjured theories about how the world worked and how to predict the future. Some examined the entrails of sheep, while others read meaning into the positions of the stars (or whatever their prevailing theory dictated) and told leaders what policies they should pursue. An astute priest would pretty quickly figure out that the best route to priestly job security was to foretell success for the politician’s/king’s/tribal chief’s pet policy course.

In today’s world, economists serve exactly the same function. They skry their data sets – a latter-day version of throwing the bones – and then, based on the theory by which they believe the data should be interpreted, they confirm the orthodox policy choices of their political masters – and so their careers prosper.

This is not to disparage economists – not at all. They really do try to come up with the best possible policies – but the range of policy alternatives is constrained by the economists’ (and the general society’s) belief system. If you believe in a Keynesian world, then you will prescribe lower rates and more fiscal stimulus during times of recession.

If, however, you believe in a competing model, such as the Austrian theory postulated by Ludwig von Mises, then you believe that smaller government, far less fractional reserve banking (if any at all), and a gold standard are appropriate. A recession should be allowed to “clear,” permitting defaulting borrowers to reduce their debts and putting the assets that collateralized their loans back on the market at reduced prices, thereby encouraging businesses to employ those now-cheaper assets in income-producing activities. (This is a very simplified explanation.)

There are other competing theories, each with its own model of how the world works. There is convincing logic and a believable rationale behind each theory. If we had adopted an Austrian model in 2008–09, we would have had a much deeper recession and unemployment would have risen higher, but the recovery would theoretically have come more quickly as prices cleared and debt was resolved. However, that period of time before the recovery began would have been devastating to the millions of families who would have faced even more crippling unemployment than we saw. That is an experiment we did not conduct, so we will never truly know whether that path might have been less painful in the long run.

Austrians are willing to face a series of small recessions as part of the price of maintaining a free economy, rather than postponing recession and trying to fine-tune what is supposedly a free market economy by means of monetary and fiscal policy. An analogy would be the theory that allowing small and controllable forest fires today might prevent a large, utterly devastating forest fire in the future. Nassim Taleb’s important book Antifragile makes a strong case that businesses, markets, and whole societies are much better off if they allow relatively minor random events, errors, and volatility to correct as quickly as possible rather than continually patching them over to avoid short-term pain. Decentralized experimentation in the economy by numerous complex actors capable of taking risks works better than a directed economy that encourages the buildup of excessive risk throughout the entire economy.

The problem is, there really is no one clearly right answer as to which economics belief system is best. I know what I believe to be the correct answer, but that belief is based on the way I understand the world – and the world is vastly more complex than anyone’s theory can be. No theory allows for a perfect solution for all participants. Rather, each theory picks winners and losers, with the overall objective of creating an economy that has maximal potential to grow and prosper.

(Sidebar: Let me tell you where Bernie Sanders and I agree. He rails against the privileges of Wall Street, crony capitalists, corporate insiders, and lobbyists, and the political favors and laws they get passed that benefit them and not Main Street. The deck is stacked in their favor. In that he is right. But his and my solutions to the problem are not similar, as he wants to create even more regulation and taxation, and I would prefer to remove all of the tax preferences and greatly reduce the regulatory morass that favors large businesses over small. I don’t want the government involved in picking winners and losers; that’s the role of the marketplace.)

So this is what it comes down to: The reigning academic theory/belief system is Keynesianism. The head Keynesians are signaling that they are going to give us negative rates. In fact, according to their theory, it would be irresponsible not to do so. They believe that if they sit back and allow the economy to sort itself out, the outcome would be far worse than anything that could be wrought by the intended and unintended consequences of negative interest rates.

We can differ with those in charge, but the experiment with negative rates is going to happen, and we need to begin to adjust – to think through how to position our portfolios and our investment strategies, our businesses, and our lives.

The Fed is run by True Believers. Just as Christianity or Islam or any other religion has believers that range across a spectrum of faith and beliefs, so does Keynesianism. At the Fed, these are deeply held beliefs: our central bankers are well convinced that the facts demonstrate the validity of their belief system.

I am reminded of the apologetics courses that I took in seminary (yes I graduated from seminary in 1974 – go figure). Apologetics courses basically teach you reasoned arguments in justification of a particular view, typically a theory or religious doctrine. We would look for logic and evidence that our particular version of Christianity was the correct and true position. Apologetics gave us the techniques and facts that would back us up!

I am not really trying to equate religion and economics, but I am saying that both rely on belief systems about how the world works, and that the behavior of believers is modeled on those systems. Paul Krugman tells us that fiscal stimulus and quantitative easing didn’t give us enough of a recovery simply because we didn’t do enough. If we had just believed more, had more faith in the effectiveness of Keynesian doctrine, we would now be well on our way to the economic promised land!

The fact that neither Europe nor Japan nor the United States have seen a recovery – that much of Europe is either in recession or on the borderline of recession, that Japan is dealing with severe deflationary pressures, and that the US is visibly slowing down does not create a question in Keynesian minds with respect to the correctness and effectiveness of their policies. I believe that both Japan and Europe are going to double down on quantitative easing and negative rates in their respective countries, and the US will soon follow.

I am glad I am not a central banker. The pressure to “do something” in the midst of a crisis must be horrific. To feel a responsibility and not be able to respond would be emotionally draining. I do not envy any of them. I think my own current belief system would probably take us in the optimal direction over the long term, but I can assure you that in the short term quite a few of my fellow citizens would not be happy with the process. And whether it is I or the Keynesians selling a particular theory, promising people pie in the sky doesn’t help them much to deal with the problems they face here and now.

The fact is that all of these economic theories have at their core political views about how the economy should be organized and managed. Including mine. That doesn’t necessarily mean mine is right and theirs is wrong. To determine the “rightness” of a theory, you generally try to conduct controlled experiments that give reproducible results. That kind of gold-standard research is simply not possible in today’s world. So we actually are forced to rely upon our pet theories as to how the world works. I am certainly not a believer in moral equivalency, but until one operative theory is thoroughly discredited (as communism was) it can remain the controlling theory for a long time.

I have a lot more to say and will do so in the future, but this letter is getting overly long, and I need to close it. I leave you with one of my favorite Yogi Berra quotes: “In theory there is no difference between practice and theory. In practice there is.” In theory the economy should respond to stimulus, and an economy that is demonstrably overburdened with debt should be pushed to increase that debt. In practice, the outcome may not be quite as salutary as the theory suggests. Adjust your world accordingly.

Your meditating on belief systems analyst,

John Mauldin
subscribers@mauldineconomics.com

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The 10th Man: Interstellar

Unless you were trapped under something heavy, you probably heard the news that a team of scientists detected gravitational waves emanating from two black holes colliding a billion light-years away. This is a really big deal, one of the biggest discoveries in theoretical physics.

A gravitational wave is actually a ripple in the fabric of space-time. If you picture the universe as a two-dimensional plane, a gravitational wave would push the plane into three-dimensional space. Since we live in a four-dimensional world (including time as the fourth dimension), a ripple in space-time actually pushes the known universe into what is known as the “bulk,” or the fifth dimension.

Huge implications here for travel through space (or time).

I used to be a big astronomy nerd when I was a kid, locked up in my room, reading space books. I actually was once interested in planetary science. Now I study finance. How depraved.

Nassim Taleb is right—finance actually is depraved. If you study finance, you study money, of course. But why is money interesting?  Because it doesn’t sit around in static piles, that you shuffle and count. It can grow asymptotically, or else simply disappear.

This is true not just of stocks and bonds, but also of currencies, which are supposed to be worth something, and even commodities, which are really supposed to be worth something.

Then you have gold, which is totally useless from a practical standpoint and whose value fluctuates dramatically.

Funny thing about money exploding or disappearing is, it’s so hard to understand that we hire physicists to figure it out. And then they come up with these really mundane solutions, like an options pricing model that doesn’t work, or a way to forecast future volatility (that also doesn’t work). None of this ever comes close to figuring out why money explodes or disappears.

Of course, the goal is to get exposure to money exploding or negative exposure to it disappearing, but people seem to do a pretty bad job of that, too.

The reason we aren’t any closer to the answer is because we keep using the wrong methods. You can get the math geeks to come up with equations to describe human behavior, but then human behavior changes or does something new, and you are back to square one.

The study of money is the study of people, and people behave in sometimes predictable, but often unpredictable ways. Just when you think you have a rubric (like Nate Silver with elections, a related field), along comes a Trump who blows apart the whole model.

I’ve always felt that finance is a very qualitative discipline. You are no worse off hiring English or history majors. It’s no accident that all the heavy hitters in this business are also really great writers.

The quants are starting to catch on, and a lot of the algorithmic traders are writing programs to mimic and predict human behavior, though it’s really just technical analysis, trend following, in a computer program. Technical analysis has an uneven reputation, but when you can quantify and backtest it and it works, the reputation gets markedly better.

Hard to argue nowadays that even weak-form EMH holds, when you have a cottage industry of very profitable systematic strategies.

Of course, there is a lot of math behind the quant stuff, and the guys doing it are mathematical geniuses, but the best of them are also very sharp market folks, with a nose for when trades start to get crowded. The quant blowup of 2007 happened because all the smart quants were in all the same ideas. So even in the world of high-level mathematics, you still have to deal with unquantifiable stuff: human behavior.

When someone like hedge fund manager Bill Ackman sees his portfolio get slaughtered by about 20% in 2015 and then double digits in the first month of 2016, that’s not just bad stock-picking. This is what happens when crowded trades become un-crowded.

Computers may be computers, but the people who program the computers are just human, and utterly fallible.

Behavioral Finance

When I taught my college finance class last semester, I’d say the most consensus long among the students was Disney (DIS), because of Star Wars.

Of course, I had been doing a bunch of work on the short side for months.

Disney has some serious problems, like declines in sports viewing and superhero movies and cable industry trends—secular stuff that’s completely out of their control. Suffice it to say that by the time the MBA students in South Carolina get bulled up on a stock, it is probably pretty close to the end.

That’s behavioral finance, in a nutshell.

This is what I do for a living. I watch the market, not the stocks, if that makes any sense. I am always collecting data. Every person I talk to on the phone, every chart I look at, every tweet or article I read, it all goes into the soup, and from that soup, I am trying to gauge sentiment.

Sentiment tells you everything. Cheap things get cheap, and expensive things get more expensive. Markets are alternately rational and irrational, because people are alternately rational and irrational. Seems like a crazy way to allocate resources, but it works better than all the alternatives.

If you want to read more about my investment process, you can choose between the monthly version or the daily.

Jared Dillian
Jared Dillian

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The article The 10th Man: Interstellar was originally published at mauldineconomics.com.